Health Care, Insurance

Standard Theory of Health Insurance

According to standard theory, risk-averse individuals prefer a monetary loss with certainty to a gamble with the same expected value. To protect against health-related financial losses, such individuals are willing to transfer income (pay a health insurance premium) to a risk-bearing entity (an insurance company) to protect themselves against monetary losses associated with illness. When these income transfers capture the expected value of an individual's medical care expenses over a contractual period, they represent an actuarially fair health insurance premium. Because such monetary transfers are voluntary, the pooling of resources by individuals with similar risk profiles is welfare enhancing.

Standard theory also suggests that risk-averse individuals will pay a “risk premium” above the actuarially fair premium to obtain health insurance. This additional payment enables insurers to make coverage available, because it compensates them for their administrative and marketing costs and allows a margin for profit. This insurance “load” represents the true economic price of insurance as it is the minimal monetary transfer above an actuarially fair premium necessary to induce insurers to provide coverage. An individual's demand for coverage will depend on its price (in theory, the insurance load, but in practice, the out-of-pocket premium), the individual's risk aversion, and the probability and size of a health-related financial loss.

Setting Health Insurance Premiums

Despite the theoretical construct of an actuarially fair health insurance premium, controversy remains as to how premiums should be established. Some view health insurance as a form of mutual aid and social solidarity among citizens and believe that premiums should be community rated, reflecting the health care experience of an entire insured group. Under this principle, all individuals pay the same premium regardless of their own health care experience. In contrast, others suggest that premiums should more appropriately reflect the actuarial value of individual health care experience (or the experience of a group of very similar individuals) and should be experience rated. These analysts assert that community rating is unfair because it imposes an implicit tax on low risks that is used to subsidize high risks. Such pricing also results in the inefficient provision of coverage as the low risks purchase too little insurance and high risks overinsure.

Moral Hazard and Adverse Selection

Because health insurance reduces out-of-pocket costs, individuals and their providers have an incentive to overuse health care. In doing so, individuals obtain additional health services whose value to them is less than the resource costs incurred in its production. This moral hazard welfare loss represents a major source of inefficiency in the provision of health care.

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